In reality, there are sometimes good reasons why the CDS cash basis does not trade at zero examples that lead to a positive basis.

That is the CDS trading at a higher spread than asset swaps are the choice of asset swap benchmark.

For example, in Euros, government bonds may assets swap to a negative spread against your rival, whereas the CDS spread cannot go negative.

The use of CDS as an efficient shorting mechanism for anyone who wants to take a short position on credit buying A CDS is a much cleaner way to express the trade than going short the bond with an asset swap and the associated repo trades involved convertible bond hedging.

When convertible bonds are bought by relative value traders, they tend to hedge the credit risk by buying CDS, putting upward pressure on prices.

This is really just another form of shorting efficiency leading to an excess demand for CDS.

And lastly, the price of the bond has an effect and a bond price below par can result in a positive basis.

To understand the last point better, imagine the basis was trading at zero, but the bond in the asset swap was trading below par.

If we buy the CDS and buy the asset swap in equal notional size, we will be flat in the event of no default, but we will be over hedged on default, resulting in a possible windfall gain.

The possibility of this windfall gain will mean that four bonds trading below par traders may buy the basis above zero, paying away an amount of money over time in return for a possible windfall gain on default.

Examples where we might have a negative basis are funding costs.

For example, if we could not borrow the money to buy the bond at the benchmark rate assumed by the asset swap, we may prefer to sell the CDS instead even at a small negative basis.

The issuance of credit linked notes such as CNS and synthetic CDOs creating these structures requires the issuer to sell CDS, putting downward pressure on prices.

And just as in the positive examples, the price of the bond has any effect.

So if the bond is trading at a premium to par, the CDS basis may be structurally negative for the windfall gain reason we discussed before, the main learning point here is that the two trades, CDS versus asset swap have similarities and they market levels should be comparable.

But be careful of spotting arbitrage opportunities that may not be there.